Saturday, March 7, 2009

When the hotdog vendor you buy lunch from talks about the impending nationalization of Citigroup, it is fair to say that nationalization risk is "priced in" Citi's (and all other financials') securities. And while the risk that the government will take over Citi, BofA and the other major banks is palpable, the upside in shorting bank stocks is very limited (BAC can only go down another $3.14 while Citi is a frequent visitor to the 99c club), especially considering the downside risk in the form of a squeeze, which can be easily observed by looking at the market action in the last 30 minutes of trading on Friday (for retail investors who bought into this short covering wave thinking this could be the indicator of a market bottom, our condolences).

Nonetheless, a unique way to play the nationalization threat, with limited downside and potentially substantial upside, does exist in the form of a Parent (HoldCo) - Bank bond basis trade.

The dramatic widening in financial CDS over the past several weeks is the result of bank CDS referencing the bank Parent (aka HoldCo), level, or the most comprehensive and risky layer of a bank.

In several instances a financial Senior - Sub relationship can be exploited via CDS, however in the case of a default event both are likely to converge to comparable recovery levels as there not yet been a case of split preferential treatment of Sr/Sub debt classes in a bank nationalization. A potentially more lucrative and less risky way to play the creeping nationalization threat is via a Bank-Parent arbitrage. Nowhere is this more evident than in the Lehman brothers bankruptcy case: Barclays, which balked at the prospect of purchasing Lehman HoldCo which contained that toxic dump of all of Lehman's worthless CMBS "assets", jumped at the opportunity of buying Lehman's Bank assets (and associated debt), even more so that it ended up being a transaction in which bank assets were purchased for nanocents on the dollar (golf clap for Lehman creditors' legal advisor Milbank Tweed for allowing this daylight robbery to occur). Lehman HoldCo debt is now trading around 13 cents while FSB/bank debt was in the 80s and virtually doesn't trade. The reason why the government may be interested in a Parent-Bank bifurcation is that roughly 70% of bank debt outstanding is at the parent level according to Bank of America, which suggests that if the government finally does come around to a dramatic recapitalization of the zombie banks, it is likely that the Bank level would be supported while the Parent would be wiped out.

The arbitrage in this case would be purchasing bonds guaranteed by the Banks while shorting bonds not guaranteed by the Bank/only by the Parent. This relationships can be seen by comparing the relative spreads of JPM's 6% bonds due 10/1/2017 (Bank guarantee, A+ rating) versus JPM's 6.125% bonds due 6/27/2017 (Parent guarantee, A rating).

As can be seen from recent market action, the bond spread has started to diverge as traders being to exploit this relationship. Nonetheless, the current spread is still only 100 bps. A Lehman-like resolution would result in the spread exploding, as Parent bonds hit cash prices in the teens, while Bank bonds drop only marginally. Also, as the worst case scenario is pari passu treatment, the spread can at most converge to 0. On a $10 million basis this implies the maximum downside is $100,000, while the upside could be well over $5 million: this should be a much more acceptable risk/return scenario to any trader who is betting on a sweeping bank nationalization, but is unwilling to take on the common stock short squeeze or creeping nationalization risk. Additionally, the trade could double up as nationalization insurance, since bank CDS are trading at levels at which it makes no sense to actually use them for "protection" purposes due to exorbitant carry costs (absent a pair trade with matched bonds, which is in fact a trade that has been aggressively implemented over the past 2 weeks, and which the administration should be very concerned about due to the perverted inherent incentives of basis holders to see the eventual bankruptcy of the underlying security).
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The problem of public pension underfunding is rapidly becoming the next major administrative nightmare as the over $1 trillion underfunding will at some point have to receive appropriate funding treatment. But public workers are not the only ones who should be very concerned as a result of pension fund underperformance, due in major part to the collapse in capital markets and pension funds' large investments in public equities. Hat tip to reader Colin who points out an interesting report from Merrill Lynch dated October 24, 2008 in which author Gordon Latter discusses the adverse impacts to shareholders of public companies with Defined Benefit and Post-Employment Benefit Plan underfunding, as these will likely see substantial ongoing drops in company earnings, as increasing pension underfunding is eventually expensed through the income statement.

The core of the problem is that the top 40 companies which have defined pension liabilities are cumulatively looking at over $100 billion in pension underfunding (based on ML's estimates from the table below).

The corresponding impact to the income statement for S&P constituents, as predicted by ML in October of last year, would be $34 billion of pension expenses in 2009. However, since then the S&P 500 has dropped another 20% implying a significantly higher amount of expensing will be necessary to catch up, assuming the market is flat from now thru year end. The feedback loop impact from deteriorating capital markets on both the balance sheets and income statements only gets worse: Merrill estimated that the total impact as companies restate pension contributions and are forced to switch strategic asset allocations out of equities into Treasuries (or vice versa) could be as large as $200 billion, leading to more shocks to a increasing less liquid stock market.

Of course, in tried fashion, nobody is willing to acknowledge the problem, and all involved parties are pushing hard to postpone judgment day. The Pension Protection Act (PPA) which was signed into law in 2006 requires companies to amortize their pension deficits over 7 years. One loophole is for companies that have a Credit Balance that would afford them a contribution holiday in 2009 (and potentially later), but as expected the rules governing Credit Balances are convoluted and outdated. Other accounting chicanery involves the usage of an appropriate FAS87 mandated discount rate, which as seen below permits the pick up of up to 125bps in pension liability discount rate accounting reduction from a purely actuarial basis. This results in an average decrease of plan liabilities by 11%, thereby somewhat moderating the whopping reduction in assets.

Lastly, there is an ongoing attempt by the American Benefits Council to obtain funding relief. In a 10 point plan, the council hopes that the sought after relief may be sufficient to help offset the current economic crisis.

None of these measure will likely matter at all in the long-run if the market remains at its current levels (or continues dropping). The median assumed asset return for companies sponsoring US pension plans is 8.0%, and, which is scarier, many companies used expected ROAs in excess of this median in order to keep funding requirements to a minimum.

These companies which "abused" the system will now be pressured by their retirees and shareholders to reevaluate their pension accounting fairly, dropping the assumption to a level in line with peers and current conditions (indicatively a $1billion fully funded pension plan lowering its assumed rate of return from 9.5% to 8% would have an additional $15 million of associated expense).

The same PPA requires companies to attain fully funded pension status within 7 years, thereby setting a somewhat loose deadline by which all hell could break loose (aerospace/defense companies can opt out until 2012). It is, of course, very likely that the administration will change this law as well as it constantly pushes back on the day when it all comes crashing down.

So what does all this mean practically?

Basically, companies will have to dramatically slash earnings estimates over and above what today's economic realities dictate. The table below, which was also created in October of 2008, demonstrates that the majority of S&P companies are facing a huge readjustment to EPS based on the continued onslaught of capital markets. While Merrill estimated a roughly 15% decrease to EPS based on adjusted pension expenses alone, the 20% drop in the S&P since then may imply an even more pronounced reevaluation of 2009 earnings, thereby augmenting selling pressure on the stocks, and further hurting pension asset returns (ergo the closed loop).

Furthermore, with regards to practicality, investors who are currently invested in companies such Unisys, First Horizon, Con Ed, New York Times, Fed Ex, Pactiv, Goodyear, Dupont (which recently reported a significant earnings miss the bulk of which was attributed to increased pension expense) and 3M should carefully reassess the bull cases here, due to the significant earnings downside potential that could arise out of pension expensing (we neglect to mention GM and F's adverse pension impact as both companies have many other things to worry about currently). Additionally, while not immediately apparent as a threat to earnings, the following companies have tremendous pension underfunding which will eventually catch up to them: LMT, RTN, AA, JNJ, XOM, VZ HON, CAT and EXC. Shareholders should proceeds with extreme caution as this topic becomes more and more noticed the by the mainstream media and the chattering heads on cable TV.
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Friday, March 6, 2009

The latest report from Prudential, courtesy of For What It's Worth, shows an eyepopping increase in the inventory of $6 million+ houses for sale in Greenwich, CT, growing at 164% in 2009 compared to 2008. While the total inventory increased by a manageable 22%, the heavy weighing toward the rich end of the spectrum is troubling. Seeing how buyers for the under $1,000,000 category are rarer than hen's teeth, the likelihood of newly liberated SAC psychologists of HR managers purchasing at 6 times that price is also 6 times less likely.

As expected, the SEC promptly granted an exemption for the ICE to begin guaranteeing CDS. ICE competitor CME Group has not received an SEC exemption and it is not clear how long it would take for the SEC to make a decision on the competitive platform.

Either way, the ICE has said it will begin backing trades in the market as soon as Monday of next week. Farewell basis trade (unless our readers feel otherwise, in which case we welcome their thoughts).
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The recent run up in oil prices has resulted in some dramatic shifts along the crude curve. When we first discussed the contango effect (and some amusing risk free ideas as a result), the 12 month spread was roughly $25.

Today's NYMEX closing crude curve shows that relationship has collapsed to a mere $7, a 70% drop! At this rate we should get backwardation within the month. This should also help long suffering USO holders, as all the pain they suffered during contango will be a magnified profit under backwardation.

At least according to survivorship bias specialist Hedge Fund Research as quoted by Bloomberg. In all likelihood the real number when factoring in the funds that stopped reporting between January and February is at least double that. HFR states that YTD returns among hedge funds are -0.59%.

HFR has traditionally been on the top end of performance estimates, with their 2008 HF performance calculated at -19%, versus a range of -18% to -29% based on a compilation of all hedge fund tracking services.
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Unlike the previous letter, this one actually is worth your time. Kyle Bass, the one man Spartan who took on the Xerxian hordes of sub-prime with his Hayman Capital (which has returned 6% in 2008, 9% in 2009 and is up 340% since inception), and won, shares some very valuable insight. Must Read.

Kyle's summary:

The world needs a “do‐over” and [a global default] would be the cleanest way to rebuilding the world's financial system. As much as I would like to think there is another path to salvation that does not include enormous pain, there is just no other way when you look at all of the numbers.

p.2: Alan Greenspan said it best when he wrote Gold and Economic Freedom in 1966p.3-1: It is an interesting point to ponder – the United States has been operating in asystem of limitless credit creation for ONLY 38 years.p.3-2: There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency.p.3-3: The Bad News? The Rest of the World Looks Worsep.4: the scorecard so far reflects a relatively mild downturn compared to the rest of the world.p.9: the results are staggeringand frightening.p.11-1: Our work suggested that there could be a "cluster" of government defaults over the next three years (or possibly sooner).p.11-2: we find that serial default is a nearly universal phenomenon[.]p.12: The fact that he thinks stealing money from the savers in his economy and confiscating itthrough the hidden tax of inflation/currency debasement should scare everyone.p.13: To be clear, we believe that the U.S. (and in fact, the world) is in an ongoing debt deflationary spiral that will likely continue for some time (possibly years). The rampant printing of currencies around the globe is not, in our opinion, likely to be immediately “inflationary” (in the common understanding of the term) as leverage comes out of the private sector and asset values continue to decline. The greater concern is the potential inflationary time bomb that grows as governments continue to borrow, print and “stimulate.” What happens to inflation when the velocity of money goes from zero to 100?p.14: default - and - 50%p.18-1: I am sure I will upset Wall Street firms and insurance companies and all of the other participants that like the old system of posting no collateral and having the marketplace opaque so they could fleece the unwary participants. It is time to have an “Adult Skate” only from now on.p.18-2: The problem is that they have already taken all of the “suckers'” money in the securitization marketplace.p.19-1: For your wealth, you must think about the enormity of this problem around the world, and what the likely governmental responses will be. I believe they only have two paths to walk down eventually.p.19-2: There will be a time to get bullish (my guess is many years from now).

Follows the speech that Vik gave yesterday in the London School of Economics. We post this before an in-depth reading, but at first blush is there a hint in there that Vik wants the elimination of mark-to-market?

An amusing snipped from the speech about Citi's purported invaluable role in the current world, aside from having its shares belonging in 99 cent stores.

Our core mission is to enable capital to flow around the world and to stimulate economic growth. In these times, cross-border capital flows from savings-rich economies to savings-short economies are going to be essential to restart global economic growth. There is no question about that. No financial institution in the world is as well positioned to provide these services as Citi. We operate in 109 nations, with more than eight of every 10 employees working in their home countries. Citi is a unique franchise, with an operating model that allows us to be both very local, and very global. [Many others talk about this. We actually do it.]

Rampant purchasing of protection last week. Net notional positive change (CDS purchasing) of $132 billion this week versus only $8 billion previously. Trading action also ramps up by over 300% with 30,348 contracts traded versus 9,538 last week. Virtually all sectors saw short-risk ramping except consumer services which was the only space with reriskng action.

Gross outstandings increased by $700 billion to $28.1 trillion, consisting of $14.6 trillion of single name notional, and index and index tranches of $13.5 trillion, versus $14.5 trillion and $12.9 trillion last week, respectively.

As we pointed out last week, the equity weakness is finally migrating to the IG/CDS world. We expect this week's derisking trend to accelerate into next (and to finally hammer the HY realm whose resiliency is about to be tested).

The market seems to have sealed the chemical company's fate, essentially saying the likelihood of bankruptcy is about 130% (give or take). Rumors are swirling that Chemtura's destitute bondholders have hired Akin Gump to help them salvage a little of what asset value the plastics maker might have left. With a full blown liquidity crisis and $375 million in notes due this July, the company at this point may at best have another 4 more months of life.
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Just hit Bloomberg: JPMorgan denies it published a report Italy is likely to default which is what Italian newspaper La Reppublica had claimed earlier.... well, you know what they say about denial. CDS at 198-203... Just a reminder - repudiation is a credit event under ISDA.

March 6 (Bloomberg) -- JPMorgan Chase & Co. said it asked Italy’s securities market watchdog Consob to investigate a rumor related to the stability of the country’s finances. The firm also disputes it is marketing a product which implies a negative view on the country’s sovereign debt, JPMorgan said in an e-mailed statement today.

***

On the other hand, it would be ironic if Italy does default one of these days... just saying.
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Few things on Wall Street are as secretive and mysterious as "Dark Pools" - stock crossing networks that provide liquidity not displayed in market order books. The biggest implication of this is that an outsized bid can be matched up with an offer in a private transaction without disclosing the transaction at all. Traditional financial markets generate liquidity by openly advertising buy and sell interest in a given venue, with real time liquidity data provided by publishing market depth (think Level 2). Dark Pools, or Dark Liquidity, as they are sometimes known, have been used more and more by brokers and funds in transacting off market in increasingly greater volume.

Some markets allow dark liquidity to be posted inside the existing limit order book alongside public liquidity, usually through the use of iceberg orders. Iceberg orders generally specify an additional display quantity, smaller than the overall order quantity. The order is queued along with other orders but only the display quantity is printed to the market depth. When the order reaches the front of its price queue, only the display quantity is filled before the order is automatically put at the back of the queue and must wait for its next chance to get a fill. Such orders will therefore get filled less quickly than the fully public equivalent, and they often carry an explicit cost penalty in the form of a larger execution cost charged by the market. Iceberg orders are not truly dark either, as the trade is usually visible after the fact in themarket's public trade feed.Dark Pools

Truly dark liquidity can be collected off-market in dark pools. Dark pools are generally very similar to standard markets with similar order types, pricing rules and prioritization rules. However the liquidity is deliberately not advertised - there is no market depth feed. Such markets have no need of an iceberg order type. In addition they prefer not to print the trades to any public data feed, or if legally required to do so, will do so with as large a delay as legally possible - all to reduce the market impact of any trade. Dark pools are often formed from brokers' order books and other off-market liquidity. When comparing pools careful checks should be made as to how liquidity numbers were calculated - some venues count both sides of the trade, or even count liquidity that was posted but not filled.

Market Impact

Whilst it is safe to say that trading on a dark venue will reduce market impact it must be noted that it is very unlikely to reduce it to zero. In particular the liquidity that crosses with you has to come from somewhere - and at least some of it is likely to come from the public market, as automated broker systems intercept market-bound orders and instead cross them with you. This disappearance of the opposite side liquidity as it trades with you and leaves the market will cause impact. In addition your order will slow down the market movement in the direction favourable to you and speed it up in the direction unfavourable to you. The market impact of your hidden liquidity is greatest when all of the public liquidity has a chance to crosswith you and least when you are only able to cross with other hidden liquidity that isn't also represented on the market. In other words you still have a trade-off: reduce your speed of execution by only crossing with dark liquidity or increase it and increase your market impact

Imputing the Existence of Dark Liquidity

There are a few ways to guess at the existence of dark liquidity. If you are watching the market depth and see that both the bid and offer have decreased by the same amount, you might reasonably assume that the trade was in fact made, but at a venue not visible to you. However this is unreliable, since there is the chance that two orders were simply canceled at the same time.

If you are actively trading at a dark venue and choose to take liquidity at a given price then you obviously have a piece of information known only to one other participant (the counterparty in the trade!). Additionally if you were completely filled you may reasonably assume that some more liquidity exists at the same price.

Gaming

Dark pools are open to gaming, but it is a risky business, predicated on being able to guess both the existence of large liquidity and the pricing mechanism being used. As an example suppose that, by whatever means, you believe that there is a large amount of hidden liquidity, say a buyer pegged to the public bid price. If the public market has much less quantity than you suspect is hidden on the bid, you can buy a similar amount of the asset, pushing up the price. Once the price is high enough, you place a limit price buy order of sufficient quantity onto the public market andsimultaneously place a limit price sell order for the total quantity you just bought on the dark venue. You now hope that the hidden order will cross with you at the current high price bringing the profit. This is a dangerous game though: how do you know that the pegged order is really in the dark pool, and how do you know what the volume is? Finally there is also the chance that another market participant will see the anomalous move, decide the market is mispriced, and take it back to the original price without you being able to liquidate your position at a favourable price.

A side effect of the bull market was that more and more broker dealers and independent firms ploughed their way into dark pool creation and management as there was a boom in stock volume over the past 5 years. Some of the most notable market participants are Instinet, ITG, Knight Capital, Liquidnet, NYFIX Millennium, and most of the bulge brackets. Lately, companies have jumped into fixed income dark pools as well, with TMCLLC being an early adopter of the idea of providing off-market corporate bond transactions, having over $1 billion in bond inventory.

We are very surprised that this market hasn't attracted much closer administrative scrutiny. In a testament to how well Wall Street guards one of its best secrets it is shocking that the Democratic congressman from Massachusetts hasn't swooped in on this like white on rice, even more so since it has the word "dark" in its title.

Unlike many other dark pools operating in the United States, MS POOL does not solicit order flow from external parties by leaking information regarding current client order flow. MS POOL also prevents the potential for gaming and manipulative trading behavior by not accepting immediate or cancel (IOC) orders.

Highlighting the inherent flaws in the entire dark pool product is quite a novel way to differentiate yourself from the competition. Also, as the Wikipedia disclosure points out, substantial dark pool usage is a terrific way for parties who may have "semi-legal" information about a company (and have access to a dark pool) to transact in its stock without alerting regulators or the general public, as dumping 100 million shares ahead of a major M&A transaction without alerting L2 at all is likely the most effective way to front run any material public disclosure.

We, of course, are not accusing anyone of abusing the system, just pointing out some of the structural variations in dark pool order flow versus regular markets. And as MS points out, it currently trades over 100 million shares per day in just one of its dark liquidity pools. Multiply this by the over 30 providers of such markets and you approach a number that could be more than half the total share volume trades on the NYSE! We hope MS is successful in signing up more clients for MS POOL ahead of what will likely be a substantial crack down on this market, which in this author's belief, is significantly more prone to abuse than the much maligned CDS OTC product.

And lastly this blurb from Mike O'Rourke's letter today. Could be bad news for hybrid equity/credit hedge funds who were short fins:

Another important exchange today was between Senator Merkley and Eric Dinallo. Merkley asked if credit default swaps use the term “swap” as opposed to “insurance” in their name because it would mean the product would automatically fall under regulatory authority of the New York State Insurance Agency if the word “insurance” was used. Dinallo confirmed that to be true. Interestingly, Dinallo noted that credit default swaps would be prohibited in many states under the “Bucket shop laws” but the Commodity Futures and Modernization Act passed by Congress specifically exempt them. Dinallo referred to the credit default swaps as the “Great Enabler” of the financial meltdown. He also explained what would happen as a result of regulation of the swaps, “I think that there has been discussion -- but then what happens to them is they become very expensive to use as a hedging instrument because you have to capitalize them like an insurance product.” In that case, the obvious solution to this aspect of the mess is simply to call them insurance. Rightly or wrongly, do not be surprised if at some point, regulators start poking around looking for investors who paired short bets in the common shares with long bets on the CDS.Sphere: Related Content

Theequity market is downnearly 4% and its not stopping there–so as we go into the close many see a test of S&P500 680 support with risks for a more dramatic flush.The race to the bottom in equities was again led by concerns about financials. XLP down over 9%. Thegold move higher suggests a return to risk aversion–up $23 orabout 3%. The equity / gold correlation was breaking downover the week and returns with avengeance. For bonds its up 3 points and holding. The safe-haven of US government paper wins out with 10Y now 2.83%; 30Y 3.516% both 15 bps lower. The yield curve flattening trade started with the BOE action and continued into the US session. This usually means trouble for the USD–therates lower, USD lower trade has beenin and out of favor until today where USD proves to be the second safe-haven of choice. First place goes to BRL–which gains and fights the tape of the rest of EM–with TRY printing 1.78 new yearly highs. The SEK was hit on the Oberg and Moody’s stories early and remains a risk off trade with EUR/SEK printing new highs of 11.68. Commodity currencies are in play and all hurting–AUD down 1%; CAD 1% - as oil drops $1.75almost 4%. The driving force of US trading this afternoon has been the talking heads–whether its Frank’s comments on TARP paybacks or Lacker’s over optimistic view of growth. But at the heart of the bear market beats the economic data which continues to dread tomorrow. With bankruptcies up 31% last year many see this asmuch worse in 2009 as jobs are lost and deflation follows. The most troubling disconnect between investors and politicians is the growing cry that Wall Street and Main Street are disconnected. But somehow the asset deflation we are living feels very much connected to the real pain of theglobaleconomy.

In a page right out of the post Sept.11 anthrax scare, a disgruntled 47 year old New Mexican, Richard Leon Goyette, allegedly mailed out 64 letters to JP Morgan which contained a white powder and text claiming anyone who inhaled the powder would die within 10 days. Additionally the sender sent a personal love letter to Jamie Dimon which contained no powder, but instead warned of a "McVeighing" of the bank's Park avenue headquarters.

While the case is still developing, Goyette seems to have an old bone to pick with JPM after he lost $63,000 he had invested in WaMu and which as everyone knows was plucked out of liquidation by JPM.

If convicted the wannabe terrorist faces 330 years in jail and fines totalling $16.25 million.

Which brings us to Chris Flowers, whose $1.3 billion investment in WaMu is exactly 20,000 bigger than Goyette's. One would presume that based on Richard's insane logic, Flowers is somewhere right now printing out 1,300,000 enveloped labels and depositing sawdust, or alternatively preparing a massive CDS bear raid from somewhere deep in the bowels of the 48th and park intersection. Of course Flowers is doing neither, as he is currently broke, after constantly trying to time the bottom in financials only to soon realize it is actually at $0.
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Just when one thought the tragicomedy couldn't get any worse. WSJ just out that Annette Nazareth, who was Geithner's pick for Deputy Secretary Treasury, has withdrawn from consideration. It is not known yet if this was because she did or did not pay her taxes.

***Update***

A second candidate, Caroline Atkinson, has withdrawn her nomination to oversee international affairs.

As WSJ reports:

The withdrawals aren't confined to the Treasury. Susan Tierney recently withdrew her name from consideration for the job of deputy secretary of energy for what a person close to her said were family reasons. Jane Garvey recently withdrew from consideration for the deputy secretary post at the Department of Transportation, according to people familiar with the matter.

People familiar with the matter said Ms. Nazareth and Ms. Atkinson withdrew in part because of the long vetting process, which had dragged on for weeks and included several rounds of intense questioning. Treasury is now said to be considering another person as deputy -- H. Rodgin Cohen, chairman of top law firm Sullivan & Cromwell LLP, who has been an adviser to virtually every firm on Wall Street, two people familiar with the matter said. Mr. Cohen declined to comment.

As our friend Chris Fountain puts it, if you are a democrat and have ever paid your taxes, you should go to D.C., there is definitely a job waiting for you there.

General Motors, which today received a going concern opinion from its auditors who had somehow missed putting that language into the doomed company's 10-K over the past several years, was much closer to bankruptcy than the general media will have you believe. As a result of the going concern statement, the company was in dire need of an amendment to its credit facility which would prevent this from translating into a full blown event of default as per the old language.

Of course, in negotiations late last night as debtwire reports, lenders represented by Ropes and Gray demanded and received and arm and a leg: in exchange for agreeing to not leave the majority of Obama voters unemployed, the bank group managed to increase the collateral coverage covenant in the loan from 2.5x to 3.25x and also cranked up their interest from L+237.5 to L+600, while putting in place a 2% LIBOR floor, AND lastly getting a 200 bps amendment fee... Obviously GM thought this was a kinda big deal to agree to all these usurious demands. Most importantly, GM was forced to abandon its course of creating junior liens on the secured collateral pool. As per previous iterations of the agreement, GM would have allowed a third party, including the government, bondholders, or the UAW to obtain a junior lien. After the going concern fiasco, bondholders are now even worse off as before they could have at least had a second lien below the Term Loan for some negotiation leverage. As it stands, they are at the mercy of Steve Rattner and the UAW's "concessions."
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For the first time in what seem forever, an external investor has funded a DIP. Today Magna Entertainment, a small Canadian racetrack operator, filed for bankruptcy which is not notable seeing how all financials seem poised to join it in liquidation purgatory. What is highly surprising is that the company managed to obtain a DIP which was not a rollup from an existing creditor, but came from MI Developments, a real-estate developer in Ontario.

MI it turns out is actually a controlling shareholder in the company, and according to Bloomberg was the third largest holder of now worthless MECA stock with 218,116 shares. Has MI simply thrown good money after worthless stock? The plot thickens - it seems MI is the stalking horse bidder for the company's various racetracks which it will purchase with $44 million cash, $15 million of cap leases assumed and a $136 million credit bid of all existing indebtedness. This labyrinthine recapitalization could only have been devised by the alchemist minds of financial advisor Miller Buckfire, who should receive props for succeeding where Lazard failed so miserably with Nortel.

Magna's Chairman Frank Stronach, in a beautiful description that is applicable to all financial institutions in the world currently, summarizes his utter failure in corporate leadership:

"Simply put, MEC has far too much debt and interest expense. MEC has previously pursued numerous out-of-court restructuring alternatives but has been unable to complete a comprehensive restructuring to date due, in part, to the current economic recession, severe downturn in the U.S. real estate market and global credit crisis. This is a voluntary filing intended to utilize a Chapter 11 process that will allow us to continue to operate the business uninterrupted while we implement a reorganization in a court-supervised environment. We expect that all employees, customers and horsemen [???] will continue to be paid in the normal course along with all post-petition vendor obligations."

Hopefully, MI did not underestimate the horsemen's expectations for recoveries in bankruptcy or else MI will realize just how brave it is to be funding a third-party DIP in a world where the apocalypse lurks just around the corner.
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Bloomberg reports that Highbridge's $8 billion multistrat fund has lost its losing touch and shockingly made money. Allegedly the fund is up 4.5% YTD. Henry Swieca, in true fashion, has been on both the bond and convertible bandwagons (which are in serious pain lately) and has returned 15% in leveraged loans and 8.5% in converts, while also generating 6% in Asia. With the LCDX making a roundtrip from 72 to 82 and back to 72 today, it will be interesting to see what happens to his leveraged-loan returns once late February, early March performance is announced.
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Everyone knew it was going to happen just not when. The when is now, according to Jon Pierson president of recruiting company 10X partners as quoted by Hedge Fund Alert. Latest market data indicate that the base salaries for portfolio managers working for medium hedge funds in the $300-$500 million ballpark, have dropped by almost 50% from $300,000-$350,000 to $175,000-$200,000, and even veteran PMs are seeing their base cut.

Additionally, performance pay will be whacked too: while PMs may not make any money at all if their books or funds have lost money (great to know if you are raking in $$$ on those shorts while all your colleagues are perma bulls and about to scuttle your fund), their percentage of the fund's performance fees (assuming you don't have a Citadelesque 100% to climb before you hit your high water mark) will be cut drastically and much better performance will be needed to even get back to historical payoff levels. Lastly, if PM's previously counted on getting 1% on the management-fee of the overall fund, this number will now be 0.50% and even 0.25% in most cases. Oh, and about those guarantees and signing bonuses... history.

So if you are a fund that is so low under the high-water mark that you will likely not earn performance revenue for years how do you hire talent - well you simply start offering "points" or "ghost shares", essentially a cut of future "profits" in lieu of a discretionary bonus, and pray the potential hire won't bitchslap you.

And if you are an unemployed PM what do you do? The most sought after positions are for PMs who have experience in liquid strategies, long/short equity, global macro, high frequency trading and distressed debt analysts. Or alternatively you can go work for boutique broker/dealers. Only problem is if you specialize in CDS, as no boutique banks have the balance sheet to trade credit derivaties so at best you will be stuck pushing 2-3 million of some garbage bonds to naive retail investors and praying for a wide bid/offer spread.
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Good article by Bloomberg catching up on the negative basis trade, and specifically on the dynamics basis holders exert on companies which are staring at the bankruptcy abyss. In a nutshell basis holders will do all they can to accelerate the filing of corporate issuers of bonds and CDS due to the asymmetric payoff they stand to gain on the CDS leg versus the bond leg.

"Defaults are one of several ways that basis holders can benefit, so it would not surprise me if names with high concentrations of basis holders encounter resistance in their efforts to restructure,” said Michael Anderson, a high-yield debt strategist at Barclays Capital in New York.

Bloomberg also brings up the point we have been pounding the table on, that CDS does not promote "bear raids" as Dick Fuld put it, but rather is a facilitator of expressing risk in distressed names:

“You’ve got more information from a side of the market that didn’t exist before,” said Brian Yelvington of CreditSights. “People point at CDS causing all of this volatility. To me, it’s always been there. People haven’t been able to place the bets they would have liked.”

Zero Hedge has written extensively on the topic of negative basis trade previously. For thoughts posted on the topic, please do a site query on the term.
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As the chart below indicates non-agency RMBS, CMBS and ABS were running about $240 billion per quarter at the market's peak, which confirms our previous point that at $1 trillion max capacity, the TALF's $1 trillion in purchase power equates to 2.7 years of issuance at the peak 2001-2005 levels, and will likely not be filled any time soon. Furthermore as the TALF appears eligible only for new ABS issuance not ABS securities created before 2009, the rally in pre-2009 ABS is indicative of speculation that the administration will adjust this mistake mid-stream and include older ABS positions in TALF eligibility (one loophole would be taking pre-2009 loans and packaging them currently). Unless there is yet another administration flip-flop on policy, the aggressive run up in older vintage ABS will be yet another governmental front-running mistake committed by most funds and result in rampant selling of these securities which had seen a big higher recently. (hat tip reader Mike)

From the rumor bag: SAC Capital's head of HR, Margaret Belden has followed the example of former in house psychologist Ari Kiev, and broken the bonds of servitude to the king of Greenwich plumbing Stevie Cohen. This leaves the few remaining traders in a quandary as they realize the dilemma of i) not being able to have a headshrinking session after blowing $100 million on progressively more illiquid positions and ii) not having anyone in the office to fire them for this loss. Margaret's move is surprising considering the fund is rumored to be up 3% for the second month in a row.

For those that remember the surreal weekend before Lehman filed chapter 11, Barclays was considered an eleventh hour white knight who would swoop in and buy the bank. These rumors were squashed after Barclays pussied out, saying it would not be able to afford Lehman without the Queen's, the Fed's and Santa Claus' blessings... Nonetheless, the bank did its diligence, and 4 days after Lehman filed, Barc used the smoke and mirrors of bankruptcy court to snatch the U.S. broker dealer for metaphorically pennies on the dollar, and literally $1.75 billion. To see how grossly the division was undervalued and just how stupid wife-beating judge James Peck was for allowing this sale to occur so fast, Barclays booked a $3.2 billion gain on the Lehman purchase, implying it had managed to sneak $1.5 billion of value out the back door, while creditors were watching their bonds plummet from 90 cents on the dollar to 15 cents.

Turns out Barclays' audacity went much further. As part of the transaction, Barclays received $4.2 billion in cash from Lehman Bros Holdco (the bankrupt entity) to cover $2 billion of bonuses and $2.2 billion of other liabilities, which Barclays was more than happy to pocket. However, new disclosure from the FT indicates that highly overpaid liquidators Alvarez & Marsal has openly questioned the validity of this transfer, claiming of the $2 billion in bonuses only $700 million was actually paid out (ironically making bankrupt Lehman one of the best bonus payers for 2008), and only $200 million of the $2.25 set aside for other liabilities was used.

Barlcays, which has not been nationalized yet, of course vehemently denied this criminal allegation, saying "Alvarez & Marsal’s position is completely without merit, baseless and a serious misunderstanding of the facts," according to Simon Eaton, a spokesman for Barclays Capital. "All of these matters were approved by the New York bankruptcy court in September 2008." So Barclays now puts the onus on the administration: well, seeing how the bankruptcy court is considering replacing judge Peck, who so foolishly approved the mother of all firesales, for his recreation of Jason Kidd's wife appreciation day, things should play out so that soon there will be nobody left to point a finger to, besides bondholders themselves who allowed this daylight robbery to occur in the first place (or maybe their overpaid lawyers who stood like toothless lepers as all this occurred, merely happy to collect their $800/hour). And since $5 billion is roughly 4 points in recovery on the Lehman bonds, which today were trading at 12 cents, these same bondholders may soon get replaced by their own LP investors for allowing 25% of value to slip thru their fingers due to laziness and stupidity.
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Wednesday, March 4, 2009

To close the day we present two different opinions, first one a relatively downbeat one by Goldman, and the second one modestly optimistic by Mike O'Rourke... note Mike's discussion on Buffett CDS - he brings up a very critical point that is true for all companies that have technicals preventing a true indication of risk either at the equity or debt levels.

A technical rally sends US shares 2% into the green but leaves few feeling any better as we closed poorly and,fundamentally,the outlook is still grim. The news from the US today was mixed at best – with the Beige Book clear on the economy calling the outlook “poor.” Service ISM better than expected but worse than last month and still below 50. The Atlanta FED Lockhart comments are also a mixed message,warning of future hikes if growth returns – similar to the Obama budget promises of new taxes. And today’s ADP report reminded us how ugly Friday’s could be – many economists are calling for 700k job losses, with a few true pessimists looking for losses upward of 800k. The UK PM Brown address to Congress proved interesting as he extolled the Congress to see past protectionism and urged another round of global rate cuts – hard to do when you are already at zero. The larger push for Brown seems to be a quiet agenda on new regulation of the global financial sector – something that leaves many waiting for more information. Investors should be getting used to waiting by now though; clarity on bank stress tests, the ‘public-private’ partnership, and mark-to-market accounting rules are still forthcoming. On the MTM issue anyways, resolution could soon be on the way: House Financial Services subcommittee is expected to hold a hearing next week on mark-to-market accounting rules. The market wants the rules suspended but the risk is longer-term pain for a short-term gain. Suspension of MTM rules will only allow zombie banks to hobble along longer and further undermines confidence in the financial sector as a whole. But for today anyways, hope for a recovery holds – and it’s best reflected in the 7% rally in oil,which breaks $45 bbl and waits for confirmation of another China stimulus package. The commodity currencies have all benefited today – from NOK, AUD and CAD,not to mention a number of Emerging Markets, BRL in particular. Relative calm has also been good for the old relationships to risk – namely EUR/JPY breaking 125.50 and in EUR/CHF holding over 1.48. But few trust the tape or believe that this bounce today can rally beyond the 720-740 resistance in S&P500, especially after the technical rejection there. Many see today as a sickly cat,if not a dead one,with the fundamentals still begging for looser policy – global ZIRP? Much hope has been put on the FED TALF and on the push for a bigger bank fix like the private-public asset buying scheme. But hope isn’t sufficient to hold back the tide of gloom. ----- Goldman Sachs

**********

Maybe we have come full circle and we are back to decoupling again. Of course, we are being facetious, but positive news out of China between expectations of increasing the stimulus and the 49 reading on China’s Manufacturing PMI indicated that there is improvement somewhere in the global economy. The Chinese economy should be able to endure this crisis in much better fashion than the rest of the world. Besides being a cash rich, creditor nation, growth economy, the top down political structure ensures that initiatives are instituted quickly. China does not suffer from ill-informed elected officials throwing terms like nationalization, etc. around. Although we would not trade the U.S. form of democracy for any other political system, it sure does make the healing process sloppy, and in some instances, more painful than necessary.

Chairman Bernanke deserves credit for standing up to the Senate Budget Committee with respect to AIG yesterday. Noting that he did not want to save AIG, but in order to protect the financial system, he had no choice, he then pushed these collective challenges back on the legislators: “I'd like to challenge the Congress to give us a framework, where we can resolve a multi-national complicated financial conglomerate like Citigroup, like AIG or others, if that became necessary.” That statement got them to back off. We all know that our politicians are not going to risk getting tied up in these messes. Bernanke should continue to take that stance going forward, and keep pushing back. In a small bit of irony, a bipartisan group of Congressman wrote a letter to Chairman Bernanke and Secretary Geithner claiming that the TALF may not be sufficient enough to help auto dealers.

On the housing front, First American CoreLogic published a report that 18% of mortgages in the U.S. have negative equity. What the headlines failed to mention was that 58% of the mortgages with negative equity were in 6 states and in the balance of the states, the average is 12%. First American notes that the 42 million mortgages in their survey represent 80% of all mortgages in the U.S. To put that in perspective, there are 75 million owner occupied housing units in the U.S.

To the market’s credit, Equities managed to post a good session despite further weakness in the Financials. The last few banks that were generally deemed “healthy” are now under siege. Since the government has failed to take a stand in favor of Regulatory Capital vs. TCE, the TARP funds have provided no help. At this point, whoever can return the funds should do so quickly. General Electric, which very well may be the last man standing in the shadow banking system, also finds itself under siege.

We are keeping an eye on a development we’re calling the “Berkshire Experiment.” Berkshire has become roundly loathed in the hedge fund community. Bloomberg reported today that Berkshire’s Credit Default Swaps have risen to record levels, implying “Junk Status.” Over the past year, throughout the financial sector, the market has witnessed a self-reinforcing process where the Credit Default Swaps of an institution would rise, prompting short sellers to pile in, and spooking long sellers as panic erupted in the common shares. Essentially, it is widely believed that the CDS market has been used to launch “Bear Raids” on common shares. We have argued the last leg down in the banks recently and that the nationalization talk was primarily a result of the downward move in the common shares. Here is why Berkshire is important. Berkshire has 650,000 A shares outstanding (with Buffett holding more than half) and 12.1 million B shares outstanding. The miniscule float makes shorting of the common stock nearly impossible, but you can buy as many Credit Default Swaps as you want. Buffett’s holders are among the most loyal, but Buffett has experienced a few setbacks just like everyone else. It is likely that only the CDS portion of this self-reinforcing two-step will be in play in Berkshire. Now, we will get to see in real time whether or not the CDS market has been creating panic in common shares or if it is simply legitimately pricing credit risk.

MGM Mirage's travails are widely known, with the most recent iteration being yesterday's announcement that it may breach covenants in the near term. And if anyone was ambiguous about the company's prospects, Debtwire reports that the company has hired restructuring advisory firm Evercore, which comes hot on the news that the casino and Dubai World have abandoned talks with Deutsche Bank, after being unsuccessful to secure a loan for the CityCenter debacle.

Debtwire reports also that the company has commenced amendment talks with a steering committee led by Bank of America, which has in turned hired Mayer Brown as legal advisor and is currently looking for a financial advisor (all you Managing Directors at Lazard reading this, call your analysts into the office stat: pitchbooks are a-waiting). Debtwire further states "The company could be in for a fight with holders of its unsecured $7 billion in bank debt, but management currently holds most of the cards, said multiple buysiders, [as] lenders have little incentive to see the company file for bankruptcy before they can negotiate some sort of security package due to the pari nature of loan with $7.5 billion in unsecured bonds." What have we always claimed about getting collateral if you want to be a bank lender?

Other losers on the deal are the overzealous buysiders who bought into the company's 13% notes of 2013 issued in November last year and already trading at 66 (soon to be trading much lower).

Turns out the only winners in this debacle are Bill Repko and David Ying of Evercore, who will likely be exclusive (and free) guests in the Kirk Kerkorian suite in Vegas for years to come.
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Reader Mike points out an interesting potential selling opportunity in AIG 1 Yr CDS, which is trading on one of the most inverted curves in CDS land. As a collapse of AIG would be equivalent to the blasphemous "credit event" of U.S. Sovereign CDS, having to pay for the settlement on 1 years in AIG seems like an oddly armageddonesque prospect. Yet unlike buying US CDS, an account selling AIG protection picks up nice solid carry assuming the world doesn't end, and if the worst happens and AIG folds, there will likely be nobody left to collect on the default and the seller can quietly tiptoe out off the trading floor into the nearest version of McFadzen's.

"We all know how dangerous it is these days to believe that the worst wont happen, and I understand all the issues around ratings-based collateral calls after the AIG mess. But with $36 bn in cash, $20 bn in marketable securities, $98 bn of access to the CPPF, $70 bn of access to the TGLP, $34 bn in tangible equity and a TCE ratio of 5.3% that any bank would die to have......why are people buying default protection for 1 yr at 15% (other than those told "hedge or be fired" on some correlation desk)? What is the catalyst for the implosion people are fearing here? Are people seeing AIG demons when maybe they shouldn't be?"
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The only US automotive company not to be on the taxpayer's payroll, Ford, earlier announced it would pursue a proactive debt for equity and cash exchange in which it would convert up to $10.5 billion of its $25.4 billion in debt at year end. The exchange is in fact a combination of three separate transactions:

$4.88 billion of 4.25% Convertible notes due 2036 which would receive Ford common stock at a premium, or specifically 108.6957 shares per $1,000 in converts. The result would be incremental dilution of approximately 530.4 million new shares, or roughly 22% of the 2.3 billion shares outstanding.

$1.3 billion cash tender offer for unsecured, non-convertible debt of which $8.9 billion is outstanding and which will be bought back at 30 cents on the dollar (including a 3 cent early tender premium) (assuming a 30 cent final conversion price this implies $4.3 billion in face notional will be retired).

$500 million cash tender offer for Ford's $6.9 billion senior secured term loan, launched by Ford Credit. The term loan will be purchased via a Dutch auction with bids ranging from 38 to 47 cents (assuming the low bid of 38 is the final one, implies $1.3 billion of the term loan will be retired).

The full table of non-convertible securities which are eligible for the conversion is presented below. The conversion is a good start on the way to viability however the next and more crucial step is to have people actually purchase cars. And this is where Ford is in a lot of trouble, seeing how even BMW barely managed to sell a whopping 10 of its 7 series sedans in all of February.

The Federal Reserve Board has approved the proposal of Atlanta-based Intercontinental Exchange (ICE) to be CDS clearinghouse. The SEC is expected to follow promptly in its approval as well. As counterparty risk is thus set to be eliminated, CDS spreads will likely widen dramatically and the CDS basis trade will collapse over the next few months as CDS and bond spread converge.
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Matlin Patterson's pet investment banking project Broadpoint announced it was acquiring another boutique investment bank, Gleacher Partners, for $67 million, consisting of $20 million in cash and $47 million in stock, and will henceforth be known as BroadpointGleacher. Gleacher which had long languished in the periphery of even smaller advisory shops, must be happy to cash out its equity ahead of the coming banking extinction wave. Broadpoint has developed over the past 2 years as a melange of bankers and traders poached off from assorted companies, with the majority of its personnel coming from banks Jefferies and Bear Stearns. Broadpoint's CEO, Lee Fensterstock, who for years used to work at Jefferies and became a close friend of David Matlin who runs Matlin Patterson, a hedge fund known to have a special place in its heart (and its building at 520 Madison) for the mid-market focused bank that recently received a Madoff subpoena, became appointed CEO of Broadpoint in 2007 after Matlin decided to take a majority stake in the company. Another close friend of David Matlin's, and also former Jefferies managing director, Tim O'Connor is currently head of Investment Banking/Restructuring after being plucked with his entire team in a lawsuit-laden poaching from even smaller boutique bank Imperial Capital. Due to the implosions of the big banks and the vast preponderance of unemployed bankers, Broadpoint may just be able to assemble a motley crew of cost-effective advisors and traders, case in point being CDS trading legend Rick Crescenzo who joined the company after his prior employer, Bear Stearns didn't quite make the turn.
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UBS announced today it is refusing to comply with the I.R.S,' demand that it turn over the names of tax evaders who had used the Swiss Banks' services. The U.S. earlier filed a lawsuit seeking to force UBS to disclose the names of 52,000 people who had major problems with accessing the help feature in TurboTax. The bank, which tangentially saw a mass exodus of its traders and salespeople in offices across the U.S., and especially in its 3-aircraftcarrier-wide trading desk in Stamford once their bonus checks had cleared, is hiding behind Swiss legal code, which does not recognize tax evasion as a crime, only tax fraud (so does that mean in Switzerland avoiding to pay taxes altogther is better than paying a little tax while comitting fraud? seems that way).

UBS released the following statement pleading total and utter ignorance of just how bad the wrath of uncle Sam can be, especially when your central bank has put your toxic assets in a bad bank thanks to his generous swap lines.

“We believe that UBS has now complied with the summons to the fullest extent possible without subjecting its employees to criminal prosecution in Switzerland,” UBS executive Mark Branson said in prepared testimony to the Permanent Subcommittee on Investigations, which held a hearing on the bank. Branson is chief financial officer of global wealth management at UBS.
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First General Electric, now BRK. Berkshire Hathaway CDS not helping market today... The implied risk of Warren Buffett's derivatives bet and his 2008 losses have pushed BRK 5 year CDS to an all time wide today, offered at 540bps after closing at 510 yesterday. Indicatively the IG11 index of investment grade names is currently at 244bps, implying the market views BRK's AAA rating a little more like BB (or the investment grade universe is massively mispriced).

Ray Dalio's phenomenal track record has finally caught up with him, as his Bridgewater Associates is now the world's largest hedge fund measured by assets under management. Nonetheless, his positioning may be precarious due to his close relationships with sovereign wealth funds such as ADIA, who, as we wrote previously, are experiencing significant losses and may eventually be forced to collect some of their cash from whatever readily available sources they have.

Many hopes and dreams reside with what so far has been the best accepted (at least by Wall Street's conventional wisdom) government program - the Term Asset-Backed Securities Loan Facility, aka TALF, aka Prime Broker Of The People, By The People, For The People. But as we have seen before (TARP 1, TARP 2, Tim Geithner) it is usually only a matter of time before those who read (instead of just repeating the talking heads) scratch the surface and sniff between the lines.

An implicit role for the TALF is to provide the role that securitizations used to provide in the good old days (and which also were one of the main factors that lead the global economy to be where it is now), as securitizationsfacilitate the reselling of leverage by allowing risk tranching (of which Iceland always somehow ended up buying the riskiest class) and further leveraging when it is finally offloaded to the end investor. The TALF launched yesterday in its non expanded version covers $200 billion of loans ($20 billion of TARP funds leveraged 10 times) supporting autos, credit cards, student loans and small business lending. Once the TALF is expanded into its fully unaccordioned state it will have access of up to $1 trillion and will support CMBS, RMBS and ABS corporate loans (through the soon the be downgraded CLOs). The three main benefits to a TALF investor are the following: the program will be non recourse (no risk aside from an initial haircut defined for any specific asset class it is used for), there will be no mark to market, and participants will not be subject to executive compensation limits. TALF has some significant limitations on the surface (and below it, as we will investigate further): the TALF only lets investors back into the AAA market (TALF is not geared at any asset classes below AAA), it does not benefit auto and credit card issuers that have become bank holding companies (due to the direct-from-Fed lower funding costs of on-balance sheet financings), and lastly, the cost of all these incremental loans will have to be funded by the Fed which is already seeking enhanced authority to issue debt and finding ways to create other monetary base expansion mechanisms.

How does the TALF work?

In summary, TALF leverages TARP funds, turning $20 billion of funds into $200 billion purchasing power (or $100 billion leveraged to $1 billion per the revised TALF definition), which as mentioned, is non-recourse and has no-remargining. This means the only risk for investors is the initial haircut, and even that should not be classified as a risk per se (more on this shortly).

The initial problem with the TALF appears its expanded size, which may have been just some more of the Fed's psychology of "picking a really big number." As Bank Of America says, the $1 trillion target size "appears outsized relative to the underlying issuance capacity of the targeted markets suggesting less impact from this program than advertised." Granted, when the TALF was first announced on December 19, it caused a dramatic tightening of AAA spreads in the auto loan, credit card and student loan space, and per the recent update, will also likely benefit the CMBS and CLO AAA spreads. One could argue, and the market would justify, that all benefits from the TALF have already been priced into AAA tranches.

The Treasury's justification for such a focus was the "$1.2 trillion decline in securitized lending" between 2006 and 2008. The figure below demonstrates the changes in level and composition of securitized lending that were being referred to:

Unfortunately for Geithner, who apparently did not read too deeply into the data, the bulk of the $1 trillion decline in securitizations came from home equity lending and non agency RMBS, which reflect the "non-conforming" mortgage market, i.e. the subprime, alt-A and jumbo origination, loans which are the cause for the credit crisis, and which are rated far below the relevant AAA level. The truly unmet market, which the Treasury is addressing is at best 20% of the revised total amount.

Thus, the focus of the TALF appears misplaced. While the original size of $200 billion is applicable to current market needs, pushing for a 5x higher total notional of securitization replacement, even after utter pandering to private participants, is nonsensical, and likely the administration had the unfortunate intent of merely shocking the market into believing that as the program now has a trillion handle, all securitization problems could be resolved. That is patently wrong.

What is in it for the investor?

The TALF will not be demand limited, as it will generate up to 20% virtually risk-free returns to investors, due to low funding levels (roughly 100 bps over LIBOR) and marginal haircuts. The simplest return calculation is taking the net spread on the assets times the leverage, the traditional formula used by all leveraged lenders. Using a prime credit card 3 year loan, this works out to 200 bps over LIBOR less funding costs (i.e. 100 bps) all times 20 (1/ asset specific haircut of 5% as seen in matrix below), resulting in the mentioned 20% return.

Based on that formula the returns would vary between roughly 7% and 20% with essentially no downside risk due to the non-recourse and non-margin nature of the TALF.

Summary

As noted above, there seems to be a gross misperception of the nature of the TALF as a product that has been created to address a "demand for credit" problem. This is wrong, as seen in the returns analysis above from a TALF investor's standpoint: the very attractive returns guarantee there will be no lack of desiring participants to use taxpayers' capital and backstopping to generate up to 20% returns. The problem is that in an overall environment of consumer and commercial deleveraging, using the 2006 peak market conditions as a guide to the program's success ignores that based on the inevitable decline in demand by potential securitizers, overall use of the program relative to peak securitization levels will decline. Therefore the $1 trillion maximum utilization target on the TALF is a pipe dream and merely one more round in the government's arsenal of shocking the market with soundbites and large numbers: its old incarnation of $200 billion would have been perfectly satisfactory, even more so as $80 billion less taxpayer capital (via TARP) would have been put at risk. The success of the program will hinge on merely avoiding more defaults and economic damage that would have been inevitable if credit availability had not been there. And lastly, the stupid shift in the administration's push to encourage demand, which will be there regardless, by removing compensation limits is, of course, another blatant demonstration of the government's misunderstanding of its own programs and the supply/demand market mechanics they create.
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